Inflation has at last compelled central banks to tighten monetary policy and bring to an end the epic era of ultra-low interest rates. Many fear this means an extended bear market is now likely. I disagree. Rather, I feel there is good reason to infer that a sideways market is in prospect. This begs the question: can you make money when markets are essentially going nowhere?
Let’s tackle first the question of why a sideways market scenario could be feasible.
The bear argument rests in large part on the association between low interest rates and broad asset-price appreciation. Higher interest rates will surely mean falling asset prices. They will also lift borrowing costs and commodity prices, depressing growth in western economies.
Factor in, too, the dire geopolitical environment and a Chinese economy weighed down by a self-imposed property bust, a zero-Covid policy and far-reaching regulatory tightening.
There are, however, grounds for believing public markets, on the whole, may be well supported in the face of these difficulties. Escalating input prices may affect profitability, but a meaningful collapse in economic activity is in no way certain.
The necessary responses to issues such as deglobalisation, geopolitics and the climate and energy crises will require higher levels of investment going forward from government and the private sector. This should assist the real economy, including some highly labour-intensive and capital-intensive industries.
We are not entering this period in the wake of a typical cycle of debt-funded investment and excess. There has obviously been a bubble in ‘disruptive’ early-stage businesses, but the impact has been felt more in asset prices than in the real economy. Crucially, the financial system in its entirety lacks the leverage that has the tendency to turn idiosyncratic events into systemic problems.
Finally, it might be argued that there has already been a substantive adjustment in prices in liquid public markets. There may be more adjustment to come, of course, but it is in illiquid assets and private markets where the greatest risks are likely to lie. Valuations for many public markets and securities are currently undemanding in absolute terms and relative to history.
These counter-balancing forces lead me to believe we face a sideways market – and may do for some time. This would be a notable development, not least because many investors take a “directional” approach. They seek to profit from markets consistently moving either up or down. Horizontal price movements manifestly fly in the face of this preference, which is why sideways markets can present a challenge.
This is not to suggest, though, that sideways markets do not produce winners. History clearly shows they do. Legendary investors such as Warren Buffett and Bill Ruane built their reputations during such periods. So how should we approach markets that are basically volatile but apparently trendless?
Lessons in finding hidden opportunities
Robert G Hagstrom, a well-known investor and an acclaimed biographer of Warren Buffett, explored this question a dozen years ago in a paper published in 2010 entitled “Who’s Afraid of a Sideways Market?” He focused on the 500 biggest stocks in the US between 1975 and 1982.
The market went nowhere during this ostensibly uninspiring period, de-rating from 12x earnings overall to an average of 7x. Yet some investors retained a capacity to enjoy outsized returns.
As the research discovered, this was because a surprisingly high number of individual stocks in the S&P 500 – 18.6% and 38% of the index respectively – went up in price by more than 100% over rolling three- and five-year periods. Although the energy and industrial sectors had the highest proportion of winners, there were gains across the board.
Such findings highlight the vital difference between the trends of a system and the trends within a system. As Hagstrom explained, most investors looked at the market as a whole and concluded nothing much was happening, but the reality was that the S&P 500 was still home to plenty of variation – and therefore plenty of attractive opportunities – during a superficially unexciting period.
And who was best equipped to identify those opportunities? Hagstrom investigated four investment approaches – valuation, capital deployment and financing, earnings quality (growth) and market reaction (short-term momentum). Valuation emerged as the most successful strategy, with momentum – the weapon of choice in recent years – faring worst.
Artemis’s own analysis of sideways markets in other regions and time periods has arrived at similar findings. For instance, the FTSE 350 largely headed nowhere between March 2013 and March 2016, yet 63 stocks went up in price by 75% or more during those three years.
We found dividend yield and earnings growth (one year forward) were the most profitable approaches in this case, with valuation neutral and size a negative contributor to returns. Meanwhile, dividend yield and valuation were the optimum strategies in Asia ex-Japan between July 2011 and July 2014, when 87 stocks – around 13% of the market – went up in price by 75% or more.
An arena for active management
What all this tells us is that navigating sideways markets is less about nailing specific sectors or themes and more about individual security selection. As Hagstrom remarked, it is about the trends concealed within a seemingly trendless system.
This means a sideways market should constitute an arena in which active managers have scope to excel. The new regime should be one in which an ability to zero in on market inefficiencies and pricing discrepancies could be particularly useful.
I am aware there is limited evidence of this at present. With the old regime still unwinding, many active managers have struggled relative to major indices. But these are early days.
If Hagstrom’s analysis and our own research are any guide, active management should increasingly come into its own. The longer the period of consolidation, the greater the challenges around asset pricing – and the more rewarding skilful individual stock selection is likely to become.
Markets may be thought of as sideways, and price movements may at least appear to be directionless. In the final reckoning, though, none of this means portfolio returns need be similarly moribund.
Paras Anand is chief investment officer at Artemis Investment Management